The DeFi Déjà Vu

Finance and Creative Destruction

The Austrian-born American economist Joseph A. Schumpeter famously popularized [1] the idea that at the heart of capitalism lies the process of creative destruction — the recurring and often painful reorganization of economic structure as old ways of doing things get displaced by innovative alternatives.

What’s (Not) Special About DeFi

Possibly the most infamous phrase in all of finance is: “This time is different.” It is certainly true that each period unfolds in the context of unique historical circumstances and it would be an oversimplification to claim that the underlying processes remain fundamentally unchanged over time. But there are also important historical regularities that should not be ignored. Before considering how these relate to some of the more unique features of cryptonetworks and DeFi, here’s a list of reasons why observing the evolution of this still nascent industry should generate some strong feelings of déjà vu:

  • There are three basic elements to financial innovation and development that are crucial for understanding DeFi within a broader context of finance. The first is the continually growing variety of financial assets/contracts and persistent attempts to simplify and democratize ways to issue, trade and monetize these assets/contracts. DeFi is merely the latest example of this. The second is the use of technology to operate financial markets. From railroads to telegraph to Consolidated Tape System to computers, the Internet, and high frequency trading bots — the financial sector has often been at the forefront of adopting new technology. Today, DeFi is leading the way in developing use cases for public blockchain networks and smart contracts. The third concerns the evolution from broker/agent (acts on behalf of others, earns commission) to dealer/principal (trades on own account, takes on risk). The shift from one to overlapping with the other has historically occurred in many financial markets, from commodities to foreign exchange to stocks to interest rate swaps to subprime mortgages, and has always amplified risk because it results in systemically important market participants taking on liabilities they may not be able to meet. [12] A similar lens can be applied to the analysis of DeFi by assessing the degree to which crypto-financial service providers such as exchange operators and prime brokerages engage in (potentially leveraged) position-taking on their own accounts.
  • After starting out as informal and marginal, emerging sectors and practices go through a process of institutionalization and professionalization. In the case of DeFi, this involves the emergence of crypto-financial protocols and institutions offering services such as data curation and disclosure, exchange, interest accounts, borrowing/lending, investment management, structured products, insurance, etc. It also includes the emergence of specialized intermediaries such as the emerging ecosystem of delegated staking providers, the creation of industry associations such as MAMA and POSA, and setting up increasingly formalized governance structures such as online discussion forums, ecosystem funds, voting dashboards, protocol rule change procedures, etc.
  • New financial systems emerge in areas with underdeveloped market infrastructure and regulatory standards, offering ample room for fraud, price manipulation, and other questionable practices. In the case of DeFi, this is amplified by certain ideological motivations and resulting technical choices that initially launched this industry. As often happens, innovation has created a mismatch between market practice and existing regulations. This has two effects. First, it triggers an ideological debate about the relative benefits of minimal and/or self-regulation versus updating external regulations (see [13], [14], [15] and [16] for examples in the context of crypto assets and DeFi). And second, it drives creative destruction, while introducing new problems and challenges. The latter tend to be misunderstood and underestimated until the experience of shock events such as financial crises. This may also happen in DeFi which is additionally exposed to new types of systemic technical and cyber security threats. The ability to handle these risks and navigate potential situations of crisis will be an important competitive advantage for DeFi networks and applications going forward. Over time, as both market participants and regulators learn, the ground will shift towards increasingly stable, compliant, and consumer-friendly systems. [I’ve discussed systemic risk mitigation in DeFi more extensively here.]
  • Financial stability boils down to two objectives. First, prudent regulation of rights and responsibilities in the context of financial contracts, which requires a difficult balance between allowing voluntary agreements and avoiding the excessive buildup of relationships that have the potential to cause undesirable outcomes such as deflationary spirals, extreme inequality, or social conflict. As DeFi grows, finding this balance will become increasingly important. And second, reducing the likelihood of an economy-wide collapse of asset/collateral prices (results in negative equity, i.e. liabilities exceeding assets) and income flows (results in insolvency, i.e. inability to continue making necessary payments). This must be achieved without inhibiting a healthy level of market discipline that helps prevent the expansion of unsustainable economic arrangements. These dynamics should be further considered in light of power relations and wealth inequality — both important determinants of social and political conflict. To give a concrete example, if the financial instrument in question is used to denominate debts and other obligations, and the economy connected to it is growing, a decreasing or fixed supply of it tends to favor asset holders, creditors, and rentiers, whereas a more inflationary supply — preferably targeted at real value creation — tends to favor entrepreneurs, debtors, and workers. [17] Such tendencies will obviously have an impact on how people perceive the fairness of the system, and this applies just as equally to DeFi as it does to traditional finance.
  • To summarize, financial innovators have a tendency to under-appreciate the reasoning behind the institutional and regulatory arrangement of existing systems, which represent the outcome of a long process of trial and error under constantly changing economic and political circumstances. In the crypto-financial industry, this is driven mainly by the appreciation of technological and societal change (“the old system is outdated”), but also a relative lack of experience and historical perspective given the youth of the industry. In other words, each generation has to go through their own practical lessons while attempting to make the most out of the unique possibilities of their era.
  • By relying on open source software, decentralized permissionless networks, cryptographic verification, and open data, DeFi enables both code and ledger forks, more user-centric control over personal information, enhanced privacy, and the ease of combining multiple protocols or applications into a single interface (composability). As the user experience of DeFi improves over time, the true potential and value of these features will become increasingly apparent.
  • DeFi is Internet-native, making it both digital and global at birth. Relative to earlier generations of financial technology, it is also more decentralized and thus difficult to censor or regulate. As such, assuming the currently existing digital divide is reduced over time, it has the potential to serve as a great equalizer, providing easy access to financial services to anyone in the world with a desktop/mobile computer connected to the Internet. Access to finance is a key component of economic opportunity, the expansion of which is foundational for an inclusive and prospering society.
  • DeFi is built on globally auditable digital ledgers and takes advantage of the trust and contract execution guarantees provided by blockchain networks. In theory, this allows for more automated risk management, as well as more granular regulatory oversight. Ideally, assuming that DeFi scales and breaks into the mainstream, it will make the financial system more efficient, transparent, and resilient. However, by enabling unprecedented levels of global integration and unfamiliar forms of financial complexity, it is also likely to drastically reduce the efficacy of national regulations and create a variety of new systemic risk factors. Understanding and addressing these, especially in situations of crisis, could have far-reaching implications to the future of the financial sector at large.
  • Apart from the deployment of physical infrastructure and the employment of the still relatively small number of people who are professionally involved in the industry, DeFi has evolved in relative isolation from the rest of the economy. As such, it is useful to distinguish between two types of systemic risk: internal and external. The first is already relevant, especially in the context of the growing importance of Ethereum (see [18]) and the leading financial applications built on top of it such as MakerDAO or automatic market makers (AMMs), such as Uniswap. [19] The second is less relevant today, but should receive more attention as DeFi becomes increasingly accessible to and integrated with the legacy financial system (see [20] and [21]), or used for coordinating activities in the rest of the economy (see [22]). This includes the growth of crypto asset allocations in traditional investment portfolios (and thus the broadening of the impact of crypto asset price volatility) and the expansion of cryptocurrency-denominated liabilities and incomes. As this new economy grows, understanding interlocking balance sheets with exposure to crypto asset price fluctuations and/or cash flows will become increasingly important in assessing the potential buildup of DeFi-related systemic risk.
  • Blockchain networks and the open financial system that is being built on top of them are part of a more general drive to hyper-rationalize and automate the global administrative infrastructure. Blockchain networks help enable bureaucratic systems of unprecedented scale in which human administrators are increasingly replaced with machines. On the one hand, this could bring incredible efficiency gains administering information. On the other hand, these systems may gradually evolve into a silicon cage of sorts — a society in which recordkeeping involves minimal subjective input, instead following a set of abstract, automatically executing rules of “the system” that itself is too extensive and complex for any single group of humans to censor or govern. To a degree, this also applies to society as we know it today. But globally scalable decentralized computing networks that are systemically important but increasingly difficult to unilaterally control will make it much more explicit.

Concluding Takeaways

Financial services delivered using open source protocols and public blockchain networks are here to stay. In the past, concerns over consumer protection, market integrity, and economic stability have played a decisive role in determining the regulatory and institutional foundations of finance — one crisis at a time. Crypto-financial technology offers unique opportunities for democratizing access to finance and making the economic system more efficient and transparent. However, it is also likely to create new forms of systemic risk, especially as the role of crypto-assets and DeFi applications grows in coordinating real-economic activity. As the emergent complexity of the system increases, the ability of humans to understand and directly control or govern it is likely to decline.

Footnotes

[1] Schumpeter, J. A. (2003). Capitalism, Socialism and Democracy (pp. 81–86). Taylor & Francis e-Library. Available here. (Originally published in 1942.)

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